Monday, January 18, 2010

With the financial crisis bringing formerly unglamorous professions into the spotlight (economists, accountants), a new one has come to claim its share: Statistics!

Last week, a report by the European Commission (the EU’s executive arm) on the egregious shortcomings of Greek budget statistics sent Greece’s sovereign CDS spreads to levels only below those of Dubai, Vennie and Argentina!

Without wishing to belittle statisticians, I’d like to suggest that, from a policy perspective, the focus on Greece is a convenient distraction from the much bigger problem facing the eurozone: The fact that the Stability and Growth Pact (SGP), both by its design and its implementation, has failed to bring stability to the eurozone (I’ll leave “growth” aside for now). Instead, the institutional framework underpinning the European Monetary Union (EMU)—of which the SGP is a critical component—has been responsible for the imbalances within the eurozone that are now undermining its stability.

The starting point here is that, in the absence of appropriate disciplinary mechanisms, governments have a tendency to spend beyond their means. This is not some abstract conjecture but a well-established fact, validated by empirical evidence and grounded on political economy arguments widely discussed in the academic literature (e.g. by Harvard’s Alberto Alesina).

Given this “natural” propensity, there is a need for a set of disciplinary mechanisms to work at different levels:

• Reputational/Cultural: In some countries, the “culture” of (or voters’ preference for) fiscal discipline is very strong. In that case, governments have a lot to lose (reputation and elections) by not adhering to fiscally responsible policies.• Rules-based fiscal framework: Empirical research (e.g. by Henning Bohn or James Poterba, who examine the fiscal performance of different US states) has found stricter and better enforceable budget rules to be associated with better fiscal outcomes.• Market discipline: In theory, markets should also help impose discipline by raising the cost (pecuniary and reputational) of unrestrained policies. (In practice, however, markets often fail to provide such discipline by reacting too late and in a non-linear fashion due to myopic behavior, benchmarking, etc).• Discipline imposed indirectly by the monetary authority. Provided that the central bank is sufficiently independent, it could help counteract the destabilizing effects of government dissaving with a monetary policy that encourages the build-up of private saving.

Unfortunately, most eurozone members have not seen any of these applied with sufficient force. For starts, governments’/voters’ preference for fiscal conservatism is highly idiosyncratic (see Finland vs. Italy or Greece) or temporary (e.g. will to adjust in the run-up to EMU accession followed by a pause/reversal). As such, it cannot possibly be taken for granted in a monetary union of 16 members (and potentially more).

In the case of monetary policy, post-EMU interest rates were way below “optimal” for countries like Spain, Ireland or Greece. Their national inflation rates were consistently above the eurozone average, while residuals from a Taylor-like rule post-EMU have been far more negative for these countries than for Germany or France (or Finland!). This is not to say that monetary policy was necessarily inconsistent with the ECB’s mandate of price stability; I’m just highlighting here the well-known fact that this particular disciplinary mechanism does not work in a monetary union.

With three out of four disciplinary mechanisms out or order, the burden falls on the fiscal rules. In fact, precisely because the other mechanisms are dysfunctional, a monetary union should have extra-strict fiscal rules with extra-strict enforcement mechanisms. But that’s not what Europe got for itself.

The SGP has been lame in more than one respect. In terms of design, the 3% deficit limit, which triggers the switch from the SGP’s “preventive” (and softer) recommendations to its “corrective” (and stricter) prescriptions, misses “the” point of debt sustainability.

First, by being too weak a benchmark to promote adjustment during recoveries;Second, by invariably creating incentives to use one-off measures, creative accounting and statistical misreporting to meet the “3%” limit;and, third, by allowing heavily indebted members to operate under the soft, “preventive” framework when they should instead be in a permanent “corrective” phase until their debt levels decline to an acceptable benchmark (say 60% of GDP… make it 80%!).

When it comes to enforcement, well, here we are entering the ultimate territory of lameness! First, once again, the process relies heavily on the corrective arm (i.e. after countries are in trouble with high deficits) rather than the preventive arm. This means that, even when/if countries eventually adjust back to a "3%" deficit, they end up there with much higher debt levels.

On top of that, a country is not automatically deemed to be in a state of excess deficit once it crosses the 3% limit; instead, the process involves first an “opinion” by the European Commission, which is then pondered about and decided upon by the European Council of Finance Ministers! Yes, that’s the very same guys whose budgets are under scrutiny!

This sham has led to all sorts of self-serving shenanigans—like, when the Council refused to issue an early warning to Germany back in 2002, or when the Council came at loggerheads with the Commission in 2003 by refusing to adopt a decision that France and Germany were running excess deficits. (The case had to go to the European Court of Justice, which vindicated the Commission).

Against this backdrop, Greece’s case is only a symptom of a broader plague of fiscal misconduct, including by “core” economies like Germany, France or Italy. While their numbers may look less provocative than Greece’s, they are far more consequential from an institutional and macro-stability perspective.

So what should change? Here are a few proposals, either from the literature or (to my knowledge) from me:

1. Enhance the SGP definition of “corrective” trigger to include debt/GDP levels. In this context, place highly indebted members under a permanent “corrective” process of adjustment until debt to GDP declines to a more acceptable level.

2. Do away with the 3% limit on the fiscal deficit, which is subject to all sorts of creative accounting, and set instead a limit on the public sector borrowing requirement. Discrepancies between Greece’s (and not just Greece’s) deficit and its borrowing requirement (after adjusting for financing items) had been raising eyebrows for years, so it’s baffling why this “cleaner” rule has not been brought to the fore. Besides, this rule would be more direct in controlling the debt/GDP level than the deficit-based rule.

3. Adopt strict, legally binding budget rules in the national legislatures, to be monitored by non-partisan fiscal councils. Governments should be made accountable to their parliaments for missing fiscal targets, both the “preventive” ones and the “corrective” ones.

4. Establish “rainy day” funds at the national level, with a rules-based contribution system that ensures a stricter enforcement of countercyclical policies, esp. in “good” times.

5. Establish a eurozone-wide “insurance-against-crisis” scheme: There may be a case for taking explicitly into account the negative externality due to misconduct by a minority of the membership. Countries could make contributions to an insurance fund, reflecting (a) their size and (b) their riskiness (debt level in excess of, say, 60% of GDP). This would boost the incentive to bring debt down, as well as establish predictability about the orderly resolution of a crisis situation.

In sum, safeguarding the “stability” objective of the SGP (and the EMU more broadly) will take bold measures focusing on stricter and more effective rules and enforcement mechanisms, In their absence, eurozone leaders and their array of supranational institutions might as well call a summit to give the Pact a different name!

3 comments:

Just stumbled on your blog having Googled originate-to-distribute and found your explanation both clear and stylish.

I went on to read and enjoy a number of your posts. The carry trade post left me hungering for more.

Do the "investors" you mention include the big banks that have sold their MBSs and ABSs to the Fed for cash and borrowed more cash from others under the government's guaranty program only to use all that cash to buy government paper?

On Wells Fargo's conference call earlier this week CEO John Stumpf mentioned they were getting 400 basis points on the carry trade.

You seem to find the carry trade benign -- but who, in the end, is paying for the banks' 400 basis points windfall?

Ellen, on your questions:Starting from the latter: Carry trading is one and the same with risk-taking: You forego the risk free rate for a riskier, higher-yielding investment. Because you’re taking risk, you want compensation—a “risk premium.” The “carry” (e.g. the interest rate differential between a 10-yr government bond and a 3m T-bill) is what you get paid to take that risk, but your final return may be higher or lower than the carry, depending on your capital gains/losses. Carry trades will be benign if risk-taking activities are calculated and not highly leveraged. Conversely, if risk-taking is funded by very high leverage, and/or involves investing in assets just because you think their price will never fall (as it happened in the boom years), it is not benign. I haven’t seen evidence of the latter in the US—yet!

On Wells’ 400bps. Indeed, a steep yield curve makes the carry look attractive, BUT: There are plenty in the market who think that long term rates right now are way too low. Meaning, they see a sell-off coming at the long end. So yes, you can play the carry—but at the risk of capital losses that will erode your carry gains altogether.

Finally—on the Fed’s MBS purchases: the Fed’s point was twofold: (a) to lower mortgage rates, which it did, thus helping all those (‘real people”) who refinanced their mortgages at rock-bottom rates; and (b) to remove risk from banks’/investors’ portfolios, thus encouraging them to use their cash to take more risk/lend. Given the uncertain economic outlook, the declining creditworthiness of potential borrowers, and the tremendous regulatory uncertainty for the banking sector, one shouldn’t be surprised banks prefer to hold government paper for now. Incidentally, bank investing in “government paper” is not exactly socially undesirable at this juncture: We should be so lucky to find investors here in the US and abroad willing to finance our gigantic fiscal deficit in the coming years at rates as low as 3.7% for a 10-year bond!